Japan and the Broken Window Fallacy

As the French economist Frederic Bastiat once observed, reconstruction activity yields no net gain in a society's wealth.

By

George Melloan

Updated March 15, 2011 12:01 a.m. ET

Japan has more than its share of troubles: an aging population, 20 years of slow economic growth, and an unstable government as reactionaries in the Diet resist meaningful free-market reform. Now comes the great tragedy of the earthquake and tsunami. One major post-disaster danger is that the Japanese authorities will mishandle the recovery, with unfortunate consequences for the global economy.

The first test for the government came early on, and its response raises questions. After the disaster last week, the value of the Japanese yen actually rose against the U.S. dollar. While that might seem counterintuitive, currency traders offered a plausible explanation.

They were betting that the demand for yen would go up as Japanese companies and the government were forced to convert some of their vast dollar holdings into yen to finance reconstruction. With the dollar already weak internationally, it didn't take much to tip the balance toward a stronger yen.

James Lucier of Capital Alpha on the market and political impact of Japan's nuclear troubles.

Unsurprisingly, this raised alarms at the Bank of Japan (BOJ). A stronger yen, already attracting international capital seeking a haven safer than the dollar, might weaken the competitiveness of Japanese exporters at a most inopportune time. The earthquake had sent the Nikkei stock index tumbling. So the BOJ embarked on a massive effusion of yen, pouring a record 15 trillion yen ($183 billion) into the market. BOJ Governor Masaaki Shirakawa promised "massive" liquidity to combat yen appreciation. The bank's action stabilized the yen-dollar exchange rate through Monday.

This is a typical reaction of a central banker to such an event. It could be argued that companies already hit with loss of property and the trauma of massive casualties in their communities should be spared, as nearly as possible, a rise in currency-exchange costs as they prepare to rebuild. Insurers were facing massive losses, already estimated at $35 billion. And, of course, the disaster increased credit risks.

But what about the danger of overreaction—not just to Japan but to international financial stability? With the Fed pumping out dollars and Europe facing sovereign debt threats to the solidity of the euro, the world has been looking to the BOJ as a possible life preserver in a sea of financial uncertainty. Are the tsunami and Mr. Shirakawa sinking that fragile hope through excessive yen creation that will weaken that currency?

There is precedent to consider. The Fed reacted similarly in 2005 after Hurricane Katrina devastated New Orleans and other cities on the Gulf Coast. It prolonged an already overly generous dollar policy at a time when the economy was recovering.

ENLARGE

Destruction isn't stimulus.
Getty Images

Despite Katrina, the U.S. economy grew 3.1% in the third quarter of that year, and it hit a growth rate of 5.4% in the first quarter of 2006. But we all now know that the consequence of the Fed's failure to tighten was a credit and asset bubble that wreaked havoc in financial markets throughout the world when it deflated in 2007.

Japan today is not the U.S. circa 2005. It suffered its asset bubble in the 1980s and paid a heavy price when the BOJ deliberately pricked the balloon to prevent its further enlargement. Its economy was not steaming through a recovery at the time of last Friday's disaster. Growth has been relatively flat this year.

Larry Summers, President Obama's former economic adviser, has postulated that post-earthquake reconstruction may even stimulate the rate of economic growth, as was the case after the Kobe earthquake in 1995. Well, maybe, although that is not certain given the damage to Japan's electric power grid from the nuclear facilities that had to be shut down because of earthquake-related cooling problems. Greater GDP growth also would hardly compensate for the massive losses in lives and national wealth. As the great 19th-century economist Frederic Bastiat taught in the "fallacy of the broken window," the GDP growth that comes from reconstruction brings no net gain in society's wealth. It just replaces, over time, what was lost. "Destruction is not profitable," he wrote.

Some economists have hoped that the disaster, by unifying the Japanese people and the political class in the task of bringing about recovery, will lead to necessary policy reforms, like a slimming of the government bureaucracy. Such can be hoped. Disasters do create new unity and resolve.

But the opposite case can be made as well. The Japanese political class, as with the current regime in Washington, is heavily influenced by Keynesian theories that see a government solution for every problem. For example, it seems unlikely that Japan will alter its postal savings system—which victimizes small savers with low returns—at a time when the government will face large new expenditures for infrastructure repairs. Nor is it likely to embark on a reduction of the massive national debt.

As economist David Malpass pointed out over the weekend, "Katrina may have subtracted from the Bush administration's ability to accomplish structural reforms on taxes, Social Security and the budget, and may have diverted attention from the housing, regulatory and monetary policy disasters underway at the time."

The Bank of Japan's reaction to last Friday's disaster does not offer encouragement in this regard. It was what might have been expected from a central bank under such circumstances, and it very much resembled how the Federal Reserve reacted to Katrina and to the financial meltdown in late 2008. But has that been such a great success?

Mr. Melloan, a former columnist and deputy editor of The Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).

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